Yahoo Deals and Smart Contracts

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Yahoo is expecting final bids for its core internet business on Monday, and things seem to be going pretty well, all things considered:

Though several bidders have acknowledged running into what one called “hairy” issues, nothing has emerged as a deal breaker. People involved in the auction describe it as competitive.

And "Wall Street expects the business to fetch as much as $6 billion." Given the drawn-out process, the earlier efforts to avoid selling the core business, and the conflicting statements after the auction was launched, you might have worried that Yahoo was not enthusiastic about actually getting a sale done, and that the auction might fizzle. But no, everything's fine.

Though there is this:

The biggest surprise: In late June, Yahoo told bidders that they could be on the hook for more than $1 billion in immediate payments to Mozilla, the company that makes the Firefox web browser.

In a 2014 deal, Yahoo promised to pay Mozilla at least $375 million a year to make Yahoo the default search engine on Firefox — about $100 million a year more than Alphabet’s Google unit was then paying for similar prominence, according to Yahoo and Mozilla filings.

The contract has a change-in-control provision -- "personally negotiated" by Marissa Mayer, Yahoo's chief executive officer -- in which Mozilla can "demand all of the remaining payments upfront if Yahoo is sold," if "the change in ownership was hurting the Mozilla brand and degrading the search experience." That will "put pressure on any winning bidder to continue Ms. Mayer’s heavy investments in search, which she has championed despite the long odds of success against Google."

So, look. I am sure that it was a commercially sensible decision to negotiate the deal with Mozilla. And it's plausible that, in 2014, Mozilla was worried enough about the future of Yahoo search that it would demand a heavy change-in-control penalty. ("We agreed to make Yahoo our default search engine for the next five years." "You think Yahoo will actually be a search engine in five years?" "Hmm good point.")

But looking back from the perspective of this auction, doesn't it look like a search poison pill? Marissa Mayer's Yahoo management committed itself to the idea that Yahoo's core internet business -- search and advertising and media -- could be turned around to become rich and giant and compete with the likes of Google. The market now seems to have rejected that idea, and core Yahoo is now more or less being sold for parts. (Verizon "would probably merge Yahoo’s internet business with AOL"; private equity would "curtail costs sharply while working out ways to profit from Yahoo’s still sizable audience"; no one seems to want to operate it as-is.) But core Yahoo arranged its business to make it really hard to back down from Mayer's ambitions: You can buy Yahoo for its parts and stop trying to compete with Google, but if you do that, you'll have to write an extra check for $1 billion (on a $6 billion acquisition). Marissa Mayer is selling Yahoo after her big plans for it didn't work out, but she'll still manage to impose those big plans on the next buyer.

Volcker.

A thing that often happens in financial regulation is that the regulators announce:

That thing you were doing, you can't do it any more.

In like five years.

This creates a window for odd things to happen. When JPMorgan lost a lot of money in the 2012 "London Whale" fiasco, a lot of people went around asking why the Whale's trading didn't violate the Volcker Rule; there were a number of plausible answers about portfolio hedging, but the most important answer was just that the Volcker Rule didn't exist yet. Congress had passed a law calling for rules against proprietary trading by banks, but the regulators hadn't gotten around to writing them yet. Now they have, and so, in what I have always found to be a puzzling addition to the Volcker Rule, banks are not allowed to own stakes in private equity funds or hedge funds. Except they are:

The industry has until July 21, 2017, to sever most ties with private funds after the Fed signed off on the last of three 12-month extensions it was permitted to grant under the Dodd-Frank Act. That means the clock is winding down for Goldman Sachs to shed as much as $7.2 billion of investments and for Morgan Stanley to unload as much as $3.4 billion.

There are two basic ways to deal with this sort of long lead time: Either you get out early, to avoid awkward public criticism and quickly move your business toward its long-term future, or you figure, look, regulators are banning this stuff because it is lucrative, we might as well hang on to it as long as we can. Eventually that gets awkward, though, like when you have to sell at the last minute. "There could be a limited secondary market for these investments and the firm may be unable to sell in orderly transactions," said Goldman in a risk factor. Of course there is a third approach, which is to restructure the stuff so that it is no longer banned. "Many of the real estate funds Goldman Sachs and Morgan Stanley invest in may not be prohibited by Volcker depending on how they’re legally set up," and Goldman at least has been thinking deep thoughts about Volcker structuring for a while. There is no need to be hasty about divesting from things prohibited by Volcker; if you ponder them at your leisure, you may find out that they're not as prohibited as you thought.

After an unknown hacker raided an experimental online venture-capital fund called DAO in June and spirited away $60 million worth of a virtual currency called ether, the fund’s creators came up with a way to recover the money. But in a bizarre twist, a lot of their investors are arguing against using it.

We talked last month about this controversy at the Distributed Autonomous Organization, a smart contract project on the Ethereum blockchain. The basic idea is that the terms of the DAO were entirely embodied in the smart-contract code that created it. A hacker exploited a flaw in that code to take the $60 million for himself -- or, depending on your perspective, one user of the DAO used a built-in function of the DAO to route $60 million to himself in a perfectly acceptable way. And developers have found a way to build a "hard fork" that will cure the hack and return the money -- or, depending on your perspective, that will retroactively change the terms of the DAO in a way that will take $60 million from its rightful owner.

Who can tell? Well, there was a poll:

A poll of ether holders on Carbonvote, a website set up to canvas user opinion on the topic, found 83% favor the fork. But the real “vote” will play out in a technical arena: Will the developers, miners and exchanges that constitute the Ethereum network choose to update their existing software with the new software?

If most of them do, the change gets implemented. If they don’t, nothing happens and the hacker likely gets to keep the funds. That group overlaps with DAO investors, but not perfectly. Supporters and opponents all are wrestling with the fact that altering the underlying software to fix a problem with one application sets a scary precedent for a network that is meant to maintain an unalterable record of its history.

If you thought that the terms of the DAO were -- as its original disclosure said -- entirely "set forth in the smart contract code existing on the Ethereum blockchain," then the hard fork, retroactively changing those terms, seems like a breach of the contract and a "scary precedent" for, not just the DAO and the Ethereum network, but for the whole concept of blockchain-enabled smart contracts as immutable objective code-driven systems not subject to human meddling and stupidity.

But you can't really have thought that. The DAO smart contract code didn't fully embody all of the terms of the DAO. Just for dumb instance, the code is in a language, and you have to interpret it somehow; the interpretation of computer languages is itself a social convention, though one that is itself normally fairly well-defined and expressed in software (and hardware). And the code does run on a blockchain network, meaning that it is subject to the physical and social state of that network. If everyone connected to Ethereum unplugged their computers, the DAO would stop running. And, the way blockchains work, if enough of the developers and miners approve a hard fork, then there's a hard fork. That should have been as much a part of expectations about the DAO as its actual code was.

Of course that doesn't answer the question of whether this fork protects people's proper expectations (that the DAO wouldn't be hacked) or thwarts them (that the DAO would operate like its code said it would). But the broader point is that every contract, every human agreement, is embedded in a much wider set of rules and social practices. In the regular world, this is easy to understand, because contract law is just a subset of the much broader rule of law. If we sign a contract saying I can murder you, I can't murder you, because no one in the real world is silly enough to think that a contract can fully determine the rights of everyone involved in the contract. In the blockchain world, they're still figuring that out.

Here is a Securities and Exchange Commission lawsuit against Roni Dersovitz and his hedge fund, RD Legal Capital, which "offered investors preferred returns of 1.06% per month (compounded to 13.5% annually)" by going to lawyers who had entered into big class-action settlements with creditworthy defendants but hadn't yet had their legal fees paid, and buying their fee claims at a discount. Or that was the idea:

To another prospective investor, Dersovitz stated the investments the Funds “are dealing with primarily, 100%, are settled cases, so there is no litigation risk in the strategy.” He explained that “the risks are duration and theft.”

But it paid a 13.5 percent preferred return? I love the notion that the only risk was theft by lawyers, but that risk was big enough to pay 13.5 percent a year.

But, no, that wasn't the only risk. According to the SEC, as much as 90 percent of the fund was actually invested in "legal receivables, the collection of which was subject to ongoing—and, at times, protracted—litigation risk." Specifically, RD Legal bought a lot of claims in a risky terrorism class action against Iran with no certainty that the claimants would ever actually be able to seize any Iranian assets to get paid. (It worked out, though.) RD Legal set up a special-purpose vehicle to hold those claims, promising 18 percent returns instead of 13.5 percent, but no one really bit, so it allegedly just chucked those claims into its main fund:

The Iran SPV attracted very few investors. Many potential investors told Respondents that they were not interested in investing in the Peterson Case for reasons including “political risk” (i.e., the investment might be impacted by United States relations with Iran), and a more general distaste for profiting from the suffering of victims of terrorism. Many of those investors were surprised to learn that by investing in the Funds, they took on an outsized exposure in the same Peterson Receivables they declined to pursue through the Iran SPV. Many of the same investors were particularly troubled that they had declined exposure to the Peterson Case through the Iran SPV, which offered a maximum annual return of 18%, only to be exposed to the same risks through funds that offered a maximum return of 13.5%.

"An attorney for Mr. Dersovitz said the SEC’s action was misguided," reports the Wall Street Journal. "'We have always been completely transparent with our investors,' he said."

People complain about the incentives of hedge-fund compensation, but a good exercise is to ponder what incentives you get from a compensation structure where investors get the first 13.5 percent return, and the manager gets the rest. If the manager invests in safe stuff that yields 10 percent, he gets nothing, with 100 percent probability. If he invests in risky stuff that yields 30 percent, he gets 16.5 percent (if it works) or, with some probability, nothing (if it doesn't work). The latter strictly dominates the former.

Elsewhere in fund management, and class actions, and entrepreneurial lawyers: Some Disney employees are suing its 401(k) plan for allowing plan investments in the Sequoia Fund, which in turn invested in Valeant, which then had troubles. "A prudent fiduciary would have recognized that ... the Plan's significant investment of employees' retirement savings in the Sequoia Fund would inevitably result in devastating losses to the Plan and, consequently, to the Plan's Participants," says the lawsuit. Inevitably! "I can't," is Josh Brown's correct response.

Whither Canada?

Why was Canada "the top destination for U.S. investors in foreign exchange traded funds through the first half of" this year, for the first time since 2010? I mean, presumably because the Canadian market is pretty heavy on resources stocks, and "equity investors are attracted by a resurgence in commodities prices from crude to gold." But there are other theories:

"Canada is considered an economy and a society that is stable, with leadership that’s trusted and respected.”

If there is not an academic finance paper examining how the returns of a country's stock market are affected by the handsomeness of its leader, there really should be.

People are worried about unicorns.

Line is fine, though. "Line Rises in Initial Public Offering, Cheering Skittish Tech Industry," is the New York Times headline. The stock closed up 27 percent in its first day of U.S. trading, "after pricing its offering at the high end of an increased range." "Line’s I.P.O., the largest tech offering since First Data went public in October 2015, is likely to encourage others," says the Times. In less happy unicorn news, here is "The Rise and Fall of Theranos: A Cartoon History," though if I am going to read a cartoon about Theranos I would prefer that it be vampire fan fiction, not factual history.

It's a reasonable rule of thumb in markets that transparency is good for the business of computer intermediaries and bad for the business of human intermediaries. To oversimplify, the role of a human intermediary is to know where the bonds are, not tell anyone, and match buyers and sellers based on her private knowledge. The role of a computer intermediary is to know where the bonds are and tell everyone, so the buyers and sellers can match with each other. It's fine, those are different skill sets; humans are better adapted to the intermediation-as-relationship-management role, while computers are better adapted to the intermediation-as-matching-engine role. Still it is a little embarrassing for us humans that, as a species, we are worse with transparency than the robots are.

Otherwise, I mean, bond investors have better things to worry about than bond market liquidity. "Every piece of analysis we do on the bond market tells us they are structurally overvalued," says an Allianz strategist who is buying bonds anyway. "The market in most countries is completely dysfunctional," says the chief investment officer of fixed income at AllianceBernstein. "There’s something of a mass psychosis going on related to the so-called starvation for yield," says Jeffrey Gundlach. "I would argue that because government bonds are so richly valued, it is a risk asset," says a Deutsche Bank allocator. "BlackRock CEO: Investors Are ‘Afraid.’" Perhaps the end of the long bull market for bonds will be made worse by a lack of liquidity. Or maybe that's just something people worry about until they have real things to worry about.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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